Back in May, I blogged about the problem of low GHG allowance prices in the EU-ETS. I explained the sound reasons for having both a price floor and a price ceiling in any allowance market where science doesn’t dictate a single do-or-die target for emissions.

At that time, I held up the California cap and trade market as a good example because the market has a price floor and I reported that the regulator (the California Air Resources Board, CARB) was on the way to adopting a price ceiling. As a member of the Emissions Market Assessment Committee (EMAC) that advises CARB on the operations of the cap and trade market, I had participated in a number of meetings on a price ceiling policy.

The CARB has now issued proposed changes to their policy on price containment, which the Board will consider at their October 24-25 meeting. While the proposed changes are a small step in the right direction, they don’t go far enough to address the fundamental risk to the market from a surge in emissions that could cause the price of allowances to skyrocket.

First, what the policy does do. The changes that the Board will consider in October would permit allowances from later years (of the 2013 to 2020 program) to be shifted to earlier years if the price rose to a sufficiently high level. This is a useful response to the concern that the first compliance period (2013-14) could have a shortage of supply. In fact, it virtually assures that the price would not rise above the highest price in the Allowance Price Containment Reserve during the first compliance period, which is about $53/MT (metric ton).

What the proposal doesn’t address is the more significant threat that there could be a supply/demand mismatch for the entire 8-year program. If market participants thought that there were not enough allowances over the 8-year period to cover the entire emissions under the cap – which could result from a number of years of strong growth in the economy and in accompanying emissions — then the price of permits for all remaining periods would soar. If that happened, moving permits from one year to another might temporarily drive down price in the “receiving” year and drive up price in the “giving” year, but that price differential would invite arbitrage through saving a permit this year to use it when it is more valuable in a later year. One market participant likened the current proposal to trying to fill a bathtub by taking water from one end of the tub and pouring it into the other.

The CARB staff analysis recognizes this (see pages 39-43) and CARB can certainly revisit the issue in the future. Waiting too long, however, raises the risk that later policy changes will come after the possibility of a very tight market has become elevated by higher-than-expected emissions and strong economic forecasts. Action at that point would be much more disruptive to the market – larger price impacts and shifts of wealth among market participants, leading to more political pressures and more lawsuits. It would still be better than no response at that point, but far worse than addressing the risk soon while it is still small.

The policy that I advocated in my earlier blog post, which is endorsed by my colleagues on the EMAC and many market participants (and by Rob Stavins), is a firm price ceiling. The way CARB would enforce such a ceiling is by standing ready to sell additional allowances at the ceiling price. Such a policy would not only limit the price in the case of exceptionally strong demand for allowances, it would also help deter speculative attacks and attempts at market manipulation. As I laid out in my May blog post it makes good policy sense to be flexible on the quantity target — rather that sticking stubbornly to what is a fairly arbitrary numerical target — if the cost of abatement is much higher (or much lower) than anticipated.

But, just as important, nearly everyone recognizes that California would not actually stick with the cap-and-trade market in its current form if the price climbed above the price ceiling level that has been discussed, which is about $50/MT in 2013 and rising at inflation plus 5% in each future year. (For context, an allowance price of $50/MT would raise gasoline prices about 50 cents per gallon.) Industry, government and some consumer groups have made clear that they don’t think the market would survive if that happened. And such a disruption in California would seriously damage the prospects for a multi-state, national or international cap-and-trade market.

Some opponents say that a price ceiling would undermine the environmental integrity of the program. But a price ceiling would have no impact at all if prices stayed below the ceiling level, so the question is whether the environmental integrity would be maintained if allowance prices soared and there were no price ceiling. The common wisdom, that the government would have to “step in,” suggests environmental integrity would quickly be sacrificed in that emergency situation.

What would happen? The Governor has the power to suspend the market if he (or she) believes that it is harming the economy. How exactly would that work? Your guess is as good as anyone’s.

Market participants can only speculate at how the state would put the brakes on an allowance market with skyrocketing prices. And that’s part of the problem. Regulatory uncertainty undermines market credibility, especially in times of extreme outcomes.

Furthermore, policy made in times of crisis is often driven by political influence more than good analysis. Read any book on the banking crisis, or California’s electricity crisis, for examples. In this case, the emergency policy intervention would have a major impact on the value of every outstanding allowance (as well as the stocks of many firms). The litigation would be endless. Addressing this risk now, before a crisis occurs, allows for development of a plan that minimizes the net impact on GHG emissions while giving market participants reassurance that they won’t be faced with either disruptive allowance prices or disruptive emergency interventions.

Opponents of a price ceiling also argue that it is extremely unlikely that prices would get to the levels at which a price ceiling would have an effect. Analysis by myself and my EMAC colleagues suggests the probability could be 10%, or possibly higher.

Other analyses conclude the probability is much lower, but ours is the only study that recognizes that there is uncertainty in the “business as usual” (BAU) emissions from which we have to reduce. The other studies take that emissions baseline as a known path for the years of the California program, 2013-2020. That’s equivalent to claiming that we know with certainty how fast the California economy will grow and how emissions intensive that growth will be for the next 7 years absent cap-and-trade.

The EU-ETS thought they knew the BAU emissions and were surprised when a recession delivered much lower numbers. The risk in California is that the economy will take off, causing very high emissions and soaring allowance prices. It probably won’t happen – in fact prices have been near the floor so far, which our study shows is the most likely outcome. But our analysis also implies that extremely high prices are well within the realm of possibility later in the program.

The ceiling level that has been discussed would only have an effect if prices had climbed to a level that nearly all politicians and market participants think is politically untenable. Until such a credible price ceiling is adopted, there remains a significant risk of disruption to both our economy and our strategy for addressing climate change.

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About Severin Borenstein

Severin Borenstein is E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business. He has published extensively on the oil and gasoline industries, electricity markets and pricing greenhouse gases. His current research projects include the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. In 2012-13, he served on the Emissions Market Assessment Committee that advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. Currently, he chairs the California Energy Commission's Petroleum Market Advisory Committee and is a member of the Bay Area Air Quality Management District's Advisory Council.